The recent move by China's top banking regulator to lower provisioning requirements will encourage commercial banks to classify nonperforming loans, or NPLs, more accurately.
This will likely accelerate loan impairment recognition and help step up disposal of distressed debt, said academics and agencies.
The requirements were relaxed after the banking regulator increased supervision over shadow banking and interbank activities last year.
Nonbank credit channels, including trust and entrusted loans, are being tightened along with nonstandard debt products.
The tighter rules, along with the implementation of regulations on asset management products, should lead to continued unwinding of financial sector leverage, wealth management products and other businesses in the sector, wrote Wang Tao, chief China economist at UBS Securities, in a recent report.
"Tight regulations on shadow and interbank activities are pushing credit back onto banks' balance sheets, which is consuming bank capital and dragging on profitability. The asset migration scale could be highly significant for some banks over the coming years, and may limit their ability to lend. The latest measures appear to be aimed at providing some relief," said Fitch Ratings in a commentary on March 9.
The regulator's plans to relax provisioning requirements and broaden the scope of eligible capital instruments provide greater scope for banks to migrate non-loan and off-balance-sheet assets into loans. The lower provision requirement would also allow banks to accelerate loan impairment recognition, said the international credit rating agency Fitch.
According to the regulator, the provision coverage ratio will be lowered to a range of 120 to 150 percent of NPLs, from 150 percent. The loan loss reserve ratio will also be cut to a range of 1.5 to 2.5 percent of loans from 2.5 percent.
New requirements will vary from bank to bank, depending on the ratio of NPLs to loans overdue for more than 90 days, NPL write-offs or disposals relative to new NPL formation, and capital adequacy levels.
If a bank has calculated 100 percent of its loans that are past due by more than 90 days as NPLs, the regulator will lower requirements on the bank's provision coverage ratio and its loan loss reserve ratio to 120 percent and 1.5 percent, respectively.
"The new rules will encourage banks to count a larger proportion of their loans that are past due by over 90 days as bad loans. This will help the banking sector present a real picture of financial risks," said Xiong Qiyue, a research fellow with the Institute of International Finance, which is part of Bank of China.
Besides, banks' annual NPL write-offs or disposals will need to be as large as the previous year to qualify them for a reduced requirement.
"This implies banks would need to actively resolve legacy NPLs and recognize new NPLs each year to stay compliant," Fitch said in its commentary.